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Small business can improve cash flow and bottom line profit with strategic equipment purchases

Most businesses need equipment to produce products and could manage cash flow with equipment leases.

Most small businesses that I work with want to own their equipment because they want to build equity in their business. They prefer to purchase equipment and have the asset be reflected on the company’s balance sheet. That is sound reasoning, and a difficult position to argue. However, equipment purchases have tax implications that some entrepreneurs fail to recognize.

Business equipment that typically lasts less than a year can be expensed in the year that it was purchased. These types of equipment are usually tools like pipe wrenches, shovels, and perhaps computer equipment. Equipment that is expected to last more than a year must be listed as a capital asset, and then the business can “expense” the asset through depreciation. This is where tax implications begin.

In the following example, the business owner made $100,000 profit in this current year. The business owner needs a piece of equipment to grow the business, and decides to purchase the equipment outright. The equipment is also $100,000, and is expected to last 10 years. So, the business owner makes the equipment purchase on the last day of the year spending all of the profit, thinking that the business will get a tax deduction for the purchase. Well, that is not exactly how it works in this situation.

The small business owner will have to pay income tax (and perhaps self employment tax) on the $100,000 profit. If the entrepreneur’s effective tax rate is 25%, this leaves the company with a cash-flow deficit of $25,000. And the taxes must always be paid, so the business owner has to come up with $25,000 for this year’s tax bill. However, the business owner was correct that the equipment purchase is eligible for a tax deduction, and that is called depreciation.

The new equipment is expected to last 10 years. The purchase price was $100,000. Using straight-line depreciation, the business owner can expect a deduction of $10,000 for each of the next ten years. Therefore, the actual cash deficit is now only $15,000 for this tax year.

Let’s look at what would happen if this piece of equipment is leased:

The small business owner may be better off if the equipment was leased for $834 per month, or about $10,000 per year, which is a deductible expense each year. The business now only has $90,000 in profit, and with an effective tax rate of 25%, the tax liability is $22,500, and there is no deficit. Therefore, the first year cash flow is $67,000 when leased, verses a $15,000 negative cash flow if the equipment was purchased.

It’s hard to remember all of these tax implications, which seem to change each year. If your business goal is wealth creation, this begins with achieving the largest possible cash flow each and every year. Equipment purchases have a tax implication, and taxes have an effect on cash flow. You will want to structure your equipment purchases with the best possible cash flow outcomes. Seek a qualified accountant that can help you assess the best way to structure an equipment purchase. And, you will also want to be familiar with section 179 of the tax code.